What is an irrevocable life insurance trust (ILIT)?
An irrevocable life trust or ILIT is an entity created to hold a life insurance policy. Its primary purpose is to minimize estate taxes by transferring ownership of the life insurance policy away from the insured. Putting the policy in an irrevocable trust generally precludes the value of the death benefit from being added to the taxable estate.
Estate planners may also use ILITs to ensure the death benefit is paid out according to the insured’s wishes. Let’s say you own a life insurance policy and your advisor team recommends putting that policy into an ILIT. In that scenario, you are the insured on the policy and also the grantor of the trust. You would assign someone else to be the trustee, or manager of the trust assets; you cannot be both trustee and grantor on the same trust.
As grantor, you would design the rules of the trust in partnership with your financial and legal advisors. Those rules specify how and when the assets are ultimately distributed to your beneficiaries. You could, for example, designate a minor child as the beneficiary of the trust. If you die while the beneficiary is still a minor, the death benefit could be held in the trust and then transferred when the beneficiary is of legal age. You could also specify payments for an adult beneficiary — which might be appropriate if that person has historically been irresponsible with cash windfalls. The trust could also handle any number of payouts to multiple family members or causes.
Once your attorney establishes the trust, you’d transfer an existing life insurance policy into it, or the trust would purchase a new policy. Know that transferring an existing policy — especially one with a large cash value — has its complexities. You would need the guidance of an experienced advisor to oversee the process. But assuming you navigate those issues, the trust would become the new owner and beneficiary of that policy.
Going forward, the trust would pay the policy premiums and, ultimately, receive the death benefit. When that happens, the trustee distributes the funds according to the rules of the trust. Once the trust has fulfilled its purpose, it can be terminated.
Incidentally, you cannot modify an irrevocable trust. The trustee can make some changes, but only with the approval of all trust beneficiaries.
Do life settlements work in ILITs?
Yes, a trustee can sell an ILIT-owned life insurance policy through a life settlement. The normal eligibility requirements for a life settlement would apply. That means the policyholder needs to be 65 or older and the policy must have a face value of at least $50,000. Most types of permanent life insurance can be sold, as can convertible term life policies.
Whether the policy is owned by an individual or held within an ILIT does not affect its value on the secondary market at all. Buyers may want to see a copy of the trust prior to making an offer — to understand any rules or restrictions in play. But beyond that, the sale of an ILIT-owned policy would follow the normal life settlement process.
Reasons to sell a life insurance policy held in an ILIT
The trustee has a fiduciary responsibility to protect trust assets and serve the interests of trust beneficiaries. There are times when a life settlement is the best course of action to preserve value for beneficiaries. Here are five examples:
Premiums are unaffordable
Ideally, the policy is earning enough in its cash value account to cover the premiums without additional funds. If that’s not happening, you as the grantor would have to fund the trust. If you don’t do that, the trust won’t be able to make the payments and the policy would eventually lapse. A lapsed policy is worthless to the beneficiaries. In this scenario, a life settlement could salvage up to 60% of the policy’s value for the beneficiaries. It would also release you from the burden of ongoing premium payments.
Beneficiaries want to withdraw funds
The process of paying policy premiums for an ILIT can be fairly complicated. As grantor, you don’t pay the premiums directly. Instead, you would make an annual tax-free gift to the trust in the amount needed to pay the premiums. This is where things get tricky. For tax reasons, many ILITs allow beneficiaries to withdraw funds from the trust. When you gift money into the trust, the trustee must notify beneficiaries in writing that the trust is receiving a gift. Beneficiaries can then withdraw their share of the gift for a period of time. When the ILIT is created, all beneficiaries should understand that they are not supposed to act on those withdrawal rights. However, a beneficiary could choose to go rogue and withdraw funds anyway. That puts the policy at risk of lapsing for insufficient premium payments. In that scenario, a life settlement could solve one beneficiary’s need for cash while also protecting some value for the other beneficiaries.
The policy is performing poorly
Not all types of life insurance guarantee the death benefit amount. For example, the death benefit on a variable universal life (VUL) insurance policy fluctuates based on premiums paid and the performance within the cash-value account. If the cash-value assets are losing value, the trustee may step in to prevent further losses. He or she could sell the VUL policy and use the proceeds to buy coverage with a guaranteed death benefit.
The estate will not exceed the federal exclusion tax
A primary purpose of having an ILIT is to prevent the life insurance from being included in your taxable estate. At one point in time, a large life insurance policy could easily push the total estate value above the federal exclusion for estate taxes. However, the federal exclusion has grown dramatically in recent years. In 1997, the federal exclusion was $600,000 — only estates worth more than that amount would incur estate taxes. In 2021, the exclusion is $11.7 million. You may have set up an ILIT in 1997, for example, with a $1 million life insurance policy. Today, it’s unlikely that the $1 million policy would push your estate above that federal exclusion limit. As a result of increases to this limit, many seniors may find there is no need to continue paying high insurance premiums while keeping the policy active in an ILIT. Instead, selling the policy through a life settlement could provide an immediate revenue stream to help cover rising living expenses in retirement.
Your beneficiaries have passed away
A trustee can legally terminate an ILIT if the purpose of the trust no longer exists. That could be the case if all beneficiaries have passed away. In that case, it might make sense to sell the life insurance in a life settlement, distribute the funds to the estates of the beneficiaries, and close out the trust.
How to increase your returns by selling a policy held in an ILIT
Only about 20% of life insurance policies actually pay out a death benefit. The remainder expire, lapse, or are surrendered back to the insurance company. That percentage applies to policies held by individuals and policies held in ILITs. If there’s a fair chance that the policy in your ILIT will not remain in force for your lifetime, selling it through a life settlement is probably the best way to maximize its value. The life settlement will generate cash — up to 60% of the death benefit value and two to five times the policy’s cash surrender value. Your trustee could then deploy that cash in some way that would better serve the beneficiaries. Examples include higher-yielding instruments or a different type of life insurance.
An ILIT can hold other instruments besides life insurance. The trustee, working under the guidance of a financial advisor, could set up a brokerage account in the name of the trust and then use the life settlement proceeds to invest in the financial markets for a potentially greater return based on higher-yielding instruments. You could choose to invest all of the money and live off the interest, or invest part of it and use the rest of the proceeds to pay for retirement expenses. You could even leave your returns as a death benefit to beneficiaries upon your passing.
A more suitable policy with a guaranteed death benefit
You could sell your policy, and purchase a new policy better suited to your needs that will enable you to achieve your retirement goals. For example, a policy with more affordable, or even paid-up, premiums or a guaranteed death benefit may be a better choice to protect the future proceeds available to beneficiaries.
Payoff debts to avoid interest
If you have debt and are paying a large amount of interest on a regular basis, you could sell your life insurance and use the proceeds to pay off the remaining balance so you don’t have to keep paying extra for years to come. Rather than let your life insurance sit in an ILIT, you can sell it to prevent further debt and interest from accumulating which can save you money over time. If you or a client has a life insurance policy sitting in an irrevocable life insurance trust and think selling might be a good option, contact Harbor Life Settlements to find out if that policy is eligible for a life settlement. The Harbor Life team can also provide a free estimate on that policy’s value on the secondary market.